Which of These 3 Fast-Casual Restaurants Is the Best Investment?

The fast-casual restaurant segment was the outperformer within the overall industry in 2013. With the highest check size and the strongest unit growth among its fast-casual peers, only one company is the best proxy for the segment's bright prospects.

In a challenging environment, fast-casual was the only restaurant segment to experience traffic growth in 2013, according to NPD research. Fast-casual restaurants are expected to take more market share from their casual-dining and fine-dining peers, as consumers trade down in an uncertain economic climate. Notwithstanding the positive outlook for the fast-casual segment, it must be emphasized that there is little customer loyalty associated with most restaurant brands. Which of the following fast-casual restaurant chains, Zoe's Kitchen(NYSE:ZOES), Chipotle Mexican Grill(NYSE:CMG) or Panera Bread (NASDAQ:PNRA), is the best positioned to thrive in the competitive restaurant industry?

Mediterranean foodZoe's Kitchen is the largest fast-casual restaurant group which features Mediterranean cuisine in the U.S. It has grown rapidly in the past few years, increasing its number of restaurants by five-fold from 21 in 2008 to 102 in 2013.

'Simple. Tasty. Fresh!', Zoe's Kitchen's slogan, best sums up the attractiveness of its food offerings. In terms of simplicity, Zoe's Kitchen prepares food using the most traditional preparation methods (grilling and baking) and the most common ingredients (e.g. fresh-from-the-garden stuff like raw vegetables and fruits). Relying on a traditional Mediterranean cooking philosophy and family recipes, it provides tasty food for its customers. Zoe's Kitchen also ensures the delivery of fresh ingredients to its kitchens every day. In addition, Zoe's Kitchen offers vegetarian, vegan, gluten-free, and low-calorie menu options for its diners.

The customer response has been positive, with internal surveys indicating that 94% of guests intend to recommend Zoe's Kitchen. Its average customer spend of $9.57 for 2013 also significantly surpassed the average check size for fast-casual restaurants of $7.40, which reflects customers' willingness to pay more for Zoe's Kitchen's higher-quality food offerings.

Secondly, Zoe's Kitchen depends heavily on a single primary distributor, which accounted for 62% of its food supplies in 2013. As Zoe's Kitchen places a strong emphasis on fresh food, its supply chain capabilities with respect to ingredient sourcing become particularly important.

Furthermore, because it is a significantly smaller company than peers Chipotle and Panera in terms of revenue, Zoe's Kitchen has limited purchasing power and economies of scale in sourcing. This is reflected in the fact that it has the lowest gross margins among its peers.

Mexican foodChipotle is the market leader in the Mexican fast-casual category with a menu focused on burritos, tacos, burrito bowls, and salads. Chipotle has been a fast grower, as it has expanded its restaurant footprint by more than ten-fold from 148 restaurants in 2009 to 1,595 in 2013.

While many restaurants now offer healthier and organic menu options to attract customers, Chipotle has gone one step further and made sourcing its key differentiating factor. Firstly, given the increased incidence of food scares, more consumers are showing a preference for 'Made in America' foods. Chipotle increased the amount of locally grown produce that it bought for its domestic restaurants by more than 20% in 2013.

Secondly, Chipotle became the first restaurant chain in the U.S. to voluntarily disclose which of its ingredients contain genetically modiﬁed organisms, or GMOs. It has already started to use non-GMO sunﬂower oil and rice bran oil in place of soybean oil in the preparation of chips and taco shells. By the end of this year, Chipotle plans to find non-GMO alternatives for its corn and flour tortillas.

Thirdly, consumer demand has also increased for naturally raised and organic products. Chipotle supports the sustainably raised food cause as much as possible by sourcing dairy products and meat from animals which are raised without the use of antibiotics or added hormones.

While Chipotle has higher food costs because of its commitment to fresh ingredients and food integrity, higher prices compensate for this. Chipotle's average customer check size of about $11.30 is significantly higher than that of Zoe's Kitchen ($9.57) and the fast-casual industry average ($7.40), which suggests that it has pricing power.

Bakery cafePanera is the biggest fast-casual bakery-cafe restaurant group in the country. Like Chipotle and Zoe's Kitchen it boasts an impressive track record of growth, as it has doubled its restaurant count from 877 in 2005 to 1,777 in 2013.

Similar to its fast-casual peers, Panera has also positioned itself as a 'fresh food' company. Fresh dough deliveries arrive at most Panera stores daily from its 24 facilities across the country, while other produce such as romaine lettuce and tomatoes also comes fresh from the fields. In addition, Panera's bakers bake through the night to deliver fresh-baked bread in the morning. Panera's employees cook items such as turkeys, shrimp, and salmon using the sous-vide method to preserve their nutritional contents.

While Panera has been an outperformer within the fast-casual restaurant space, it is still second to Chipotle in terms of average check size and unit growth. Panera's average customer spend of $9.39 is higher than the fast-casual segment average of $7.40, but it is lower than Chipotle's $11.30. With respect to new store growth, Panera's 2008-2012 unit compound annual growth rate, or CAGR, of 8% is half of Chipotle's 16%.

While Panera's nationwide fresh dough facility network and farm-to-fork capabilities for fresh produce serve as strong competitive advantages, rivals could still match them with sufficient capital and time. In contrast, it is far more difficult to replicate Chipotle's brand equity, which is now synonymous with food integrity in the industry.

Foolish final thoughtsAmong the three fast-casual restaurants which all have 'fresh food' as a key selling point, Chipotle is the best positioned to defeat the competition with its reputation for sourcing naturally raised, organic, and non-GMO products. This is validated by Chipotle's superior gross margin in relation to those of its peers at around 26%. Therefore, Chipotle is my top pick among the fast-casual restaurant companies to benefit from market share gains by the fast-casual segment.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Mark is a private value investor and is the author of CheapskateInvesting.com website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.